Crossing Over

In the mid-1990s, Mark Bredin got the message loud and clear: If he wanted to have a future with Merrill Lynch, he had to get with the new program. He had to “evolve” from the kind of broker Merrill taught him to be when he joined the firm in the 1970s — a super salesman with a fast dialing finger and a knack for moving clients in and out of positions as the markets changed and the firm's recommendations dictated. He would become an asset gatherer for the company's individually managed accounts program and learn to thrive on annual fees rather than daily commissions.

Bredin, who had built a $120 million book, says he devoted four years to learning the individually managed account (IMA) process — to master the asset-allocation models, to become proficient in Modern Portfolio Theory statistics and memorize the strengths and weaknesses of the dozens of portfolio managers in Merrill's program. And — this was the really hard part — he learned how to sell the new process to his clients. His production dropped by half immediately. “There were days, hours, weeks, literally, spent to bring in a new account,” he recalls. “And I hadn't been paid a dime.”

However, the deeper he got into the new way of doing business, the more confident he grew. Managed money was, he realized, the vehicle for bringing institutional-quality financial planning to retail investors. But it also occurred to him that he didn't need Mother Merrill to thrive in this new milieu.

So, after 22 years at the brokerage giant, he decided that he could do it better on his own, and in August 1997 he went independent, hiring Lockwood Advisors as his behind-the-scenes manager/research group. What dislodged him? “The bottom line is I wanted a book that would be more clearly my book once it was annuitized.”

Turns out he was right to assume that his customers were more Merrill's than his. “I was very disappointed to find out that none of my managed accounts followed me,” he says. In retrospect, he figures he should have expected that. “Merrill had its name on everything, every performance report, every statement, every month, over and over and over again. My clients couldn't separate me from Merrill. They couldn't understand the value I was bringing.” Now, on his front door and on the account statements are the words, Bredin Investment Services.

Bredin's story has a happy ending. He rebuilt his new business to more than $160 million in less time than it took to get his old $120 million book.

Still, misgivings about putting down the phone, turning away from the ticker and crossing over into the fee-based, separate account business remain widespread among brokers. Despite all the advantages, all the pleading and prodding by management, brokers are simply suspicious of the IMA world.

Why? On the one hand, the investment consultant lifestyle does look attractive. If you have to monitor money managers, not dozens of positions and funds held by hundreds of clients, day-to-day market volatility is less harrowing and investment oversight is less time-consuming. As one broker put it, “Going to managed money will get me out on the golf course more since I won't have to stare at my computer all day long. Hell, I could even do my job from the beach.”

But there's the downside. Not only is the transition painful — brokers can go through years of lower production as they learn the ropes and recruit new clients — but also there is a nagging suspicion among brokers about how their relationships with clients change. “I think management would like to do away with most of their producers and end up with the relationships, just have teams of people servicing the accounts,” says a broker who joined UBS PaineWebber through an acquisition and left five months later. “Going to managed money would be like cutting my own throat. I think management should be more hands-off. You do your business the way you know how to do it.”

Indeed, other brokers share Bredin's fear of losing control of clients once they entrust their investments to money managers, albeit ones their broker picked. “The firms love it,” says a broker at a regional firm, “because it wraps the client more tightly to the firm. You, the broker, get marginalized. All you are doing is getting paid to bring in the money. The client realizes that you are not so valuable after all.”

Whatever pangs the average broker feels about crossing over into the new role of investment advisor, management at top wirehouses and many smaller firms do not share the sentiment. Virtually every major firm has made a strategic decision to pursue high-net-worth clientele with an IMA-centered strategy. And their efforts are showing results. Since 1998, the percentage of assets in the IMA business, broadly defined, has doubled to $769 billion, according to Boston-based research firm Cerulli Associates. It is now accounts approaching 15 percent of assets at the top five wirehouses.

Depending upon whose prediction you believe, assets will reach $2.6 trillion to $5 trillion by 2010. Mutual fund companies, fearing that their investors will be lured by the cachet of an IMA and the tax benefits that a customized portfolio can bring, are launching IMA products and retooling their marketing machines to push them.

A New Twist

Indeed, the next permutation of the IMA is hitting the market — a vehicle that could further reduce the amount of decision-making done by reps. It's called the unified managed account (also known as a multidisciplinary account or diversified strategic portfolios). The benefit is to place several different managed accounts run by different managers into one account. The asset allocation decisions are made by the manager of all the underlying managers. The idea is to make sure that the growth manager isn't selling Philip Morris while the value manager is buying it. But under this scenario, the broker merely becomes the manager of the manager of the manager — got that? “It's packaged and handed down to the broker,” says Jack Rabun of Cerulli. “That would remove the rep even further from the asset allocation process.”

What is clear is that, despite the big push by firms to get all brokers with the new program, the swelling assets in IMAs are controlled by a relative handful of top brokers. Cerulli estimates that 5 percent of wirehouse brokers control 80 percent to 90 percent of the IMA assets that the firms have under management. That figure takes on greater significance when you consider that those wirehouses have 75 percent of the market. “Basically, the business is being driven by a small cadre of high-end, corner-office brokers,” says Cerulli analyst John Payne.

Where does that leave the average producer, who is being cajoled, pushed — virtually flogged — into accepting the fee-based model? “There is a middle tier who hopes to make a transition someday,” says Payne. “But there is a low-end tier that is simply used to conducting business based on transactions and doesn't have the education to migrate.”

In many cases, brokers may not have the education or the intellectual capacity to carry it off. “The bulk of brokers out there are still one-off salesmen, investment generalists who will sell anything to anyone who can be convinced to buy it,” says one industry veteran who works for a multibillion dollar money management firm that offers IMAs on nearly all the big broker/dealer platforms. “There's no plan. No process. They are basically selling machines. All they do is sell, sell, sell.”

Meanwhile, life for those traditional brokers grows increasingly uncomfortable as the firms dream up new ways to induce the crossover to the managed accounts model. At its branches in Texas, Merrill Lynch, for example, is testing a new program called Super Nova, which limits the number of clients a rep may have to 200. Super Nova also mandates at least 12 phone consultations per year and four face-to-face meetings with each client. Under the Super Nova regime, Merrill management has told its Texan rank and file, they will double their production in 12 to 18 months.

A Step Up

Nationwide, Merrill has already increased payouts on fee business and lowered commission payouts, except on big trades. Just about every brokerage on the Street, Cerulli says, has revamped its pay package to punish transactions and reward fee business. (The notable exception is Salomon Smith Barney, which doesn't have to. Its brokers are steeped in an IMA culture, because Smith Barney owns the former E.F. Hutton, which pioneered the IMA business in the 1970s.)

Even as brokers balk at the plunge into the managed accounts business, they acknowledge that the strategy makes sense. In a Prince & Associates survey, about one-third of the brokers who sold mostly mutual funds agreed that managed accounts are the next step up and are important in attracting wealthy clients. But for now, they are not taking that step.

Why? What's the hold-up? It comes back to the fear of the near-term pain to achieve a long-term gain — a sacrifice that brokers are understandably leery about. Cerulli says that it takes three to five years of reduced earnings to complete the transition and rebuild a book around IMA customers. The separate account sale is a much more involved and time-consuming process. It can take anywhere from three to six months or longer to close a new account.

“It's not an easy conversion, and brokers are going to resist that, especially after coming out of a couple of down years,” says Len Reinhart, CEO of the Lockwood Family of Cos., the fast-growing independent IMA platform. “If you are trading every day and then decide you are going to switch to fee-based asset management, you must now spend your time convincing clients to convert. While you are educating, you are not selling. You can't do both, so your transaction business drops simply because you are not spending as many hours smiling and dialing.”

Bredin calls it his “brown-out period.” The broker works longer hours and has to adjust to a different kind of psychic reward. Instead of the instant gratification of making a smart call, getting a client into a good position, and reaping a commission, the IMA broker gets rewarded over a period of years. That's not like the adrenaline rush of trading.

“The basic conflict,” says Payne, the Cerulli analyst, “is that all reps are economic animals and tend to think in the short term, like stock investors, and not three or five years out. They can't see that far down the road. But the benefits, economically speaking, are in fact better. The fact is that brokers stand to generate more in commissions if they migrate to the wrap.”

Brokers also complain that the firms are not helping. Even as management is exhorting brokers to move to IMAs, branch managers are still pushing for monthly production quotas. “The firms talk out of both sides of their mouths,” says one former PaineWebber broker. “They want you to hit X dollars a month and they want you to convert to managed money. If I convert, I'll take a hit. You know converting might be the right thing to do. But, hey, why should I?”

George Vogel, who speaks with hundreds of wirehouse brokers in his role as national sales director of Northern Trust, believes the bigger hangup is that brokers don't know how to go back to their existing base of clients and say that the way they did business before is no longer the best way. “They're trying to sell separate accounts the same way they did a product, and that's not working,” Vogel says. The better way to look at the IMA is as a financial planning process run by the rep. The individual managers should be regarded as plug-and-play solutions to fulfilling a client's financial goals.

Another complicating factor is the need to bring in new money, rather than counting on conversions. A broker at a mid-sized regional brokerage says that in many cases it just doesn't make sense to try to convert existing clients. “If I have a $1 million account that I am generating $40,000 in commissions off of, why would I want to wrap it at 2 percent and cut my fees in half?” This broker, who only has 5 percent of his clients' assets in IMAs, says that his main business is buying and selling fixed income investments for his clients anyway. “So, they get charged $500 for a $100,000 bond in a mark up, I'm supposed to call them up and wrap it? They'd pay more, and then they'd ask, ‘Why would I want to pay a fee for something you've been doing more cheaply anyway?’”

IMAs are only good, in this broker's view, for new money, people who have received a rollover or lump-sum distribution — or for people with $400,000 and up who have enough money to spread among different managers.

A veteran broker based in Philadelphia also cautions colleagues not to put too much faith in the IMA style, for fear that it will give the firm too much control. “That's why I only do some of my business in managed accounts.” The broker says that 50 percent of his business is still trading equities. “It's good to be diversified. I've been a broker since 1980 and I've seen too many fads come and go. Remember when discount brokerages were going to put us out of business?”

The Latest Fad?

What happens when the IMA fad — if it is one — runs its course? “I've got a feeling that in the high councils of the wirehouses they are de-emphasizing the broker,” says a broker based in the South. “Think about it. It's pretty expensive to pay brokers out 40 or 45 percent of the commission. If the firm can get me to wrap my business, it's more like the firm's clients.” Once everyone has moved their business over, management could then cut the payouts. And there is little recourse brokers have to fight back, he fears.

Wirehouse managers say such fears are unfounded. “I don't get it. Most clients don't even know who their money managers are,” says an executive at a regional brokerage who asked not to be identified. “They only know the broker. So I think that's just an excuse.” However, he adds, management has not overlooked how difficult the transition is. “Brokers just think there's a lot of rocket science to it. It's not really any harder than picking mutual funds.”

Whether it's pleasant or painful, rocket science or rudimentary, the IMA format seems inevitable for the major firms. “Eventually the brokers will be dragged into it,” says Lockwood's Reinhart. After all, the system does work well for clients. The process of fitting a client with a managed account, he notes, results in an institutional-quality investment policy statement, in which goals and needs and a plan of action are codified. And it eliminates the suspicion by clients that brokers are recommending trades simply to get commissions.

In fact, says the regional broker/dealer executive, “I tell my brokers that the best way of looking at it is to paint this picture: They add the value with the asset allocation work and to position the money manager as merely a commodity solution in that model. It's all in how you position it.”

Producers should see some beauty in it, too. As every broker has been told repeatedly, IMAs tend to throw off a more stable, dependable revenue stream — an annuity — that can dampen the sting of bear markets. In the 12 months ended last October, brokers who depended primarily on transactions for their meat and drink (and who participated in the Prince study) suffered production declines of more than 50 percent. Compare that to the best reps — “wealth management” specialists — who enjoyed a 2.2 percent gain in production.

Says one broker: “I got almost no complaints from my managed account customers last year. Their accounts were much less volatile.”

For those reasons, the IMA business is here to stay. Stephen Gresham, an executive with Phoenix Investment Partners, which owns 11 managers representing around $65 billion in IMA and institutional money, says it's becoming a necessary instrument for survival in the business.

“If you are a generalist, you are vulnerable to your clients growing out of you,” he says, explaining that the typical client progression is investment, then financial planning, then estate-transition planning. “Investors need someone to look not just at their investments — that's only part of it — but their aggregate wealth, like estate transfer issues, taxes, all that planning stuff.”

At the end of the day, says Chip Roame of market researcher Tiburon Strategic Advisors, it will be the demands of consumers that make IMAs mandatory. “It may be five to seven years before every consumer article mentions separate accounts,” he says. “But, if you are going to remain in this industry for the long run, you'd better be moving down this separate account path.”

The cold reality is this, in Roame's view: “The way an industry transitions is to let the old dogs die off and teach the young pups the new model,” he says. “Perhaps converting his book to fees is not the right thing for every 55-year-old broker at Merrill or Smith Barney to do. The big brokers bring in a junior broker to work their transaction business while they sell the separate accounts business, or vice versa.”

However it plays out, the crossover to the IMA world is changing the landscape of the brokerage industry — and the lives of registered reps.

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